Judging by the barrage of Registered Retirement Savings Plan (RRSP) information you would think making a contribution before the March 3rd deadline is a slam dunk no matter who you are.
The truth is; it doesn’t make sense for a lot of people – especially if you’re young.
In most cases it’s better to pay down debt than contribute to a registered retirement savings plan. In some cases paying down your mortgage is money better spent.
I don’t just say this. I lived it. My story goes back more than 20 years. Sure, mortgage amounts are higher now and mortgage rates are lower, but the formula still makes sense.
In 1991 my wife and I purchased our first home with a $90,000 mortgage. Our initial payments were $420 twice a month until the debt was paid off in 18 years. At the time mortgage rates were higher. For the sake of simplicity, let’s say the average rate through the life of the mortgage was 9 per cent.
That brought the total principal-plus-interest cost of owning our home after 18 years to $181,440.
As is the case with most young people our incomes were low and money was tight, so we made paying down our mortgage a priority before contributing to our RRSPs.
Over the first three years of the mortgage we increased our payments by the bank’s maximum annual allowable limit of 15 per cent. In the first year we hiked our payments to $483, in the second year we increased them to $555, and in the third year to $639.
By raising payments in the first three years of the mortgage - when the balance owing is the highest - that 18 year amortization period was reduced to 10 years.
By the time the house was paid off in 10 years the total principal-plus-interest cost was $142,316.
We saved $39,124 in interest and owned our house outright eight years early.
After a decade in our careers, and no more mortgage payments, we finally had the money to get serious about our RRSPs – and the timing couldn’t have been better.
While we were neglecting RRSP contributions over the previous decade the total allowable amount (known as carry-forward) accumulated, making contribution limits a non issue.
We were also both in higher tax brackets. Ten years earlier we were paying about 20 per cent federal and provincial income tax. By then our tax rate was 32 per cent.
That means for every $1,000 contributed to an RRSP we saved $320. If we contributed $1,000 to our RRSPs in our previous tax bracket we would have only saved $200.
Other spinoff benefits
While we played catch-up with our RRSPs we used that $40,000 we saved in interest payments, and the rest of the equity built up in our house, as a down payment for our next house.
Since then, our mortgage payments and RRSP contributions are more balanced. Mortgage rates are lower and income tax rebates from RRSP contributions are higher.
Yes, we will be fully taxed on our RRSP withdrawals in retirement, but by then we expect to come full circle to the lowest tax bracket. With our current mortgage paid off and no more RRSP contributions to make, our day-to-day living expenses will be lower – putting us right back on a 20 per cent tax range.
In other words, we will only pay $200 on each $1,000 withdrawn.
Oh, one other thing. Paying down debt ahead of schedule puts you in the good books with your bank. Folks with sparkling credit ratings are rare. When it comes to negotiating borrowing rates and fees, your banker will do just about anything to keep you from walking out the door.